True Economics is about original economic ideas and analysis concerning everyday events, news, policy views and their impact on the markets and you.
Enjoy and engage!

Thursday, January 15, 2015

15/1/2015: 2015 Outlook for Ireland: Domestic Bliss & Foreign Squeeze

This is an unedited version of my article for the
Village Magazine, January 2015 (link here)

December data on Irish economy is painting
a picture of a major slowdown in growth momentum and once more highlights the
troubling nature of our national accounts statistics. With that in mind, and
given the spectacular tremors rocking the global economy outside the
well-insulated doors of our Department of Finance, Irish economy is set for an
eventful 2015.

Let’s take stock of the prospects awaiting
our small haven for tax-optimising MNCs and regulations-minimising foreign
investors in the New Year.

Domestic
Bliss

On domestic front, three drivers of
economic recovery are offering some fireworks over the next 12 months. Here
they are, in order of their importance.

The ongoing shift in MNCs activities here
from profit-booking to cost-based transfer pricing, colloquially known as
‘contract manufacturing’. In simple terms, this means unprofitable low margin
activities are outsourced by MNCs to their subdivisions and other MNCs located
abroad, and resulting revenues are booked into Ireland. Official GDP rises
here, while our domestic economy stands still. In H1 2014 this game of accounting
shells has accounted for 2.5 percent of the 5.8 percent recorded growth in Irish
GDP. In other words, some 43 percent of the growth ‘miracle’ that is Ireland
Inc. was bogus. We don’t have detailed analysis of Q3 2014 data to determine
the broader impact of ‘contract manufacturing’ yet, but the National Accounts
data is not encouraging. The gap between the National Accounts-reported exports
of goods and the same exports reported in our Trade Statistics is growing once
again. Over Q2 and Q3 2014, this stood at a whooping EUR7 billion more than
what a historical average implies. That is, roughly, 7.65 percent of our entire
GDP over the same period. If we correct National Accounts data for this
discrepancy, cumulative Q2-Q3 2014 GDP in Ireland would have posted a 0.4
percent decline year-on-year, not a rise of 5.4 percent recorded in the
official statistics.

The second driver to the upside is also
MNCs-focused. Budget 2015 introduced massive incentives for the MNCs to book
into Ireland intellectual property. Instead of the notorious Double Irish we
now have an even more generous Knowledge Development Box. This reinforces
already absurd change to the National Accounts estimation practices that
re-labels R&D spending into R&D investment. The combined effect of both
factors is likely to be more R&D ‘imports’ into Ireland. Latest data shows
that overseas-originating patents filled in Ireland rose 22.4 percent year on
year in Q3 2014. And that is before the ‘Knowledge Development Box’ opened its
welcoming lid. As 2015 rolls on, expect more GDP supports from the new
‘investment’ products to hit the market here. Just don’t count on new jobs and
higher domestic incomes to materialise out of this ‘smart economy’ any time
soon.

The third force likely to propel Irish
growth to new highs is the ongoing squeeze on building and construction sector
imposed by a combination of a credit crunch, Nama assets-disposal strategy and
woefully poor regulatory reforms that de facto cut down supply of buildable
land and redevelopment sites, funding for development and dried out planning
applications pipeline. The result is rising rents (GDP-additive) and prices
(so-called ‘investment’ side of the national accounts) amidst deepening misery
of rising business costs and escalating cost of living. Added up, Irish
property sector ‘revival’ is now yet another force that simultaneously
transfers money from the households and firms into the pockets of rent-seekers
and the Government, whilst gilding with fools gold national accounts.

Foreign
Squeeze

The domestic bliss of GDP growth described
above will be severely challenged in 2015 by the continued deterioration in the
global economic conditions. Here we have some serious flash points of risks,
trailing back from 2013-2014 and some new ones that are likely to emerge in
2015 on their own right.

Back at the beginning of 2014, expectations
for global growth recovery in 2015 were driven by rosy forecasts for North
America and the Emerging Markets.

Euro area was expected to post rather sluggish,
but nonetheless above 1 percent recovery in 2014 and rise to close to 2 percent
annual growth rate in 2015. Fast forward to today. Latest forecasts suggest
near-zero growth in 2014 followed by ca 1 percent growth in 2015. So Europe’s prospects
are bleak. That’s roughly 35 percent of our indigenous exports trade in the
bin. But at least low growth is likely to delay the inevitable rise in interest
rates, giving our heavily indebted households another stay on execution.

The U.S. miracle of economic recovery is
heavily dependent on interest rates policy not reverting back to rising rates
and in all likelihood, the U.S. Fed might just oblige. Should the Fed change
its mind, all bets are off: we might see a slowdown in the U.S. recovery and
with it – a fall-off in the U.S. demand for Irish exports, both indigenous ones
and MNCs’.

The UK is a great example of the fragility
also present in the U.S. economy. Like the U.S., the UK is heavily dependent on
supportive monetary policy. And, ahead of the U.S., its economy is starting to
hit serious bumps. Latest data shows continued declines in house prices, while
demand is stagnating and inflation is slipping to long-term lows. Last time we
saw UK inflation at current levels was in 2002 – amidst the dot.com bubble-induced
recession.

Take U.S. and UK markets and we have over
50 percent of demand for Irish indigenous exports put under rising risk.

Which leaves us with the rest of the world.
Here, the Emerging Markets are tanking, fast. Brazil is in an outright recession.
Russia is slipping into one at a speed of a rock falling through the foggy
ravine. China is on the brink of a major de-acceleration in growth, and that is
under rather rosy predictions. India is enjoying some warm afterglow of
expansionary monetary policies, but the question is – for how long. South
Africa is moving sideways: a quarter of contraction is followed by a quarter of
anemic growth.

Irish Government Budget 2015 projections
were based on following assumptions:

-Irish GDP growth of 3.9 percent
or 0.85 percentage points above the IMF forecast from October and 0.6
percentage points below November forecasts by the OECD

-Euro area growth of 1.1 percent
or bang on with IMF and OECD forecasts, as well as the EU Commission, but the
risks are still to the downside in all of these forecast.

-U.S. growth of 3.1 percent,
virtually identical to the IMF forecast and current consensus amongst the
economists, but some business surveys suggest growth closer to 2.4-2.5 percent.

-UK growth of 2.8 percent or 0.1
percentage points above the IMF forecast from October and OECD forecast from
November. More recent forecasts published in early December suggest UK economy
might expand by 2.4-2.6 percent in 2015.

Global headwinds are not favourable to
Ireland, although we do have some aces in our sleeve. These aces are:
aggressive tax optimisation and already suppressed domestic demand, the two
drivers that might, just might return that 3.9 percent expansion in 2015.

Still, for now, the forecasts arithmetic suggests
that the Government really did miss a major opportunity in Budget 2015. You
see, the pesky problem is, as the Irish Fiscal Advisory Council estimates show,
Irish growth at 3.5 percent in 2015 will mean the Government missing on the
illusive 3 percent deficit target. As the above forecasts slip back over time, the
3.9 percent growth assumption is likely to be revised closer and closer to that
critical point at which the Government risks losing face in front of the
proverbial International Markets. And that won’t go too well in the Government
buildings.

Add to the above some other silly
assumptions made in the Budget, such as static current expenditure for
2015-2018 horizon and zero policy change, and you get the idea. Over recent
months, the Government has revised its spending plans in relation to Irish
Water by some EUR300 million. And over the next 12 months it will have to
revise its agreements with the Trade Unions on public sector costs moderation.
Then, there is the political cycle that simply commands that the Government
unleash a torrent of budgetary giveaways onto electorate itching to send the
FG/Labour coalition into the proverbial recycling bin of history.

All told, the real economy is likely to
continue underperforming into 2015, just as it did in 2014. In the first 3
quarters of this year, total domestic demand (a sum of private and public
consumption and investment, plus changes in the stocks of goods and services in
the economy) was up just 2.18 percent year on year in real terms. Over the last
three years, covered by the current Government policies, total domestic
economic activity has expanded by a miserly 0.29 percent in real terms. That is
less than half the rate of growth in GDP over the same period. And the latest
quarter has been even less impressive, with domestic demand falling 0.3 percent
year on year, same as in Q3 2013.

So tighten those belts for one more year of
pain: the slimming down of Irish economy is not over yet.

Disclaimer

This blog represents my personal views and is not reflective of the views or opinions held by any company, contractor, client or employer I work for currently or have worked for in the past. These views are not an endorsement to take any action in the markets or of any political position, figures or parties.

“It is not true that people stop pursuing dreams because they grow old, they grow old because they stop pursuing dreams.” Gabriel Garcí­a Márquez

Nassim Nicholas Taleb was asked whether public protests in Athens is a Black Swan Event. He replied: “No. The real Black Swan Event is that people are not rioting against the banks in London and New York.”

"Getting worse more slowly is not the same as getting better", Prof. Brad DeLong